So far, we’ve learned that we should be investing in unrelated asset classes and holding those investments for a long time. But how do we choose which asset classes, and how much to invest in each?
This is known as asset allocation, and it’s the single most dominant influencer of long-term investment performance.
Make a sensible choice, then stick with it
Most books recommend you assess your “personal appetite for risk”, and then based on the return you’re seeking, an appropriate asset allocation can be identified. But studies have shown that we humans are awful at assessing our own appetite for risk. When times are good, we feel brave. When times are bad, we feel conservative.
Decision paralysis, overanalyzing, and continually changing one’s mind about asset allocation is detrimental to long-term performance. Most investors I know—myself included—have at some point found themselves jumping in and out of various allocations, all the while, watching their investment performance decline.
In this guide, we’re focusing on what’s important—that you start investing now, and stick to a plan. We’ll therefore skip personal risk assessment and just suggest some conservative approaches that should work well for anyone.
And lucky for us, the data shows that in the long run, sticking to your allocation choice is far more important than having picked the “perfect” one in the first place!
Two proposed allocations
In this chapter, we will propose two conservative allocations. Later, we will recommend the specific investments to buy that correspond to the asset classes in each of these plans. (For more allocation options, visit the portfolios section of this site.)
Option 1: The Classic
Simple and diverse. During the 34-year period from 1974 to 2008—the data I have available—allocations like The Classic had an annual rate of return of about 9%.
- Stocks, 50%
- Bonds, 50%
Option 2: What I do
My personal portfolio is a slight variation of an asset allocation proposed by the late Harry Browne, called the Permanent Portfolio. During the 34-year period between 1974 and 2008, this allocation also had an annual return of 9.3%, but with the benefit of a much lower volatility.
The Permanent Portfolio is based on the idea that there are four possible states of the economy:
For maximum diversification effect Browne identified for each economic condition the most volatile asset class, and proposed to invest equally in each.
- Prosperity → Stocks, 25%
- Inflation → Gold, 25%
- Deflation → Long-term government bonds, 25%
- Recession → Cash, 25%
In a later chapter, we’ll see exactly how to purchase these portfolios.